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Overview of the Tax Treatment of Corporate Debt and Equity

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Overview of the Tax Treatment of Corporate Debt and Equity OVERVIEW OF THE TAX TREATMENT OF CORPORATE DEBT AND EQUITY Scheduled for a Public Hearing Before the SENATE COMMITTEE ON FINANCE on May 24, 2016 Prepared by the Staff of the JOINT COMMITTEE ON TAXATION May 20, 2016 JCX-45-16 CONTENTS Page INTRODUCTION AND SUMMARY ........................................................................................... 1 I. PRESENT LAW ....................................................................................................................... 4 A. General Rules ...................................................................................................................... 4 1. Issuer treatment of debt and equity ............................................................................... 4 2. Holder treatment of debt and equity ............................................................................. 7 3. Acquisitions and dispositions ..................................................................................... 12 B. Distinguishing Between Debt and Equity ......................................................................... 13 1. In general .................................................................................................................... 13 2. Regulatory authority pursuant to section 385 ............................................................. 15 C. Rules to Address Stripping of U.S. Corporate Tax Base in the Case of Nontaxed Holders .............................................................................................................................. 17 1. Earnings stripping ....................................................................................................... 17 2. Tax treatment of certain payments to controlling exempt organizations .................... 18 D. Rules to Address Corporate Base Erosion Without Regard to Holder’s Tax Status ........ 19 1. Corporate equity reduction transactions ..................................................................... 19 2. Debt expected to be paid in equity .............................................................................. 20 3. Applicable high-yield discount obligations ................................................................ 21 4. Interest on certain acquisition indebtedness ............................................................... 22 E. Rules to Address Tax Arbitrage in the Case of Borrowing to Fund Untaxed Income ..... 23 1. Interest related to tax-exempt income ......................................................................... 23 2. Debt with respect to certain insurance products ......................................................... 25 3. Dividends received deduction reduction for debt-financed portfolio stock ................ 27 F. Rules to Match Timing of Tax Deduction and Income Inclusion Relating to Debt ......... 29 II. DATA WITH RESPECT TO DEBT AND EQUITY............................................................. 31 III. TAX INCENTIVES UNDER PRESENT LAW FOR FIRM CAPITAL STRUCTURE ....... 43 A. Tax Incentives for Debt .................................................................................................... 43 B. Comparison to Debt: Tax Incentives for Equity ............................................................... 52 C. Tax Incentives to Create Hybrid Instruments ................................................................... 54 D. Tax Incentives to Substitute Other Arrangements for Debt .............................................. 57 E. Financial Accounting and Other Considerations .............................................................. 58 i INTRODUCTION AND SUMMARY Introduction The Committee on Finance of the Senate has scheduled a public hearing on May 24, 2016, titled “Debt and Equity: Corporate Integration Considerations.” This document1 has been prepared for that hearing by the staff of the Joint Committee on Taxation. The first part of this document presents an overview of Federal income tax rules relating to debt and equity, and some of the statutory limitations on the tax benefits of each. The overview includes the treatment of both issuers and holders, and the treatment of each in the event of a business downturn in which the instrument becomes worthless. The second part of this document presents data regarding nonfinancial business sector debt and equity and other business debt over several decades. The third part of this document discusses the tax incentives created by the present-law tax treatment of debt and equity. Summary Business enterprises and their investors have business reasons to structure capital investment as either debt or equity. Investors may prefer varying levels of risk, and, for example, may seek different levels of priority in the event of the bankruptcy of the business. Businesses can issue interests to investors that have varying levels of control over the enterprise and degrees of participation in profitability or growth of the enterprise. The tax law generally contains no fixed definition of debt or equity. Taxpayers have considerable flexibility to design instruments treated as either debt or equity but which blend features traditionally associated with both. Differences in the Federal income tax treatment of debt and equity create incentives to use one or the other depending on the tax characteristics of the issuer and of the particular investor. In general, a corporate issuer is not subject to corporate tax on amounts that it deducts as interest on debt. By contrast, dividends, which are generally not deductible by the payor, come out of after-tax income of the corporation. Debt instruments can permit the accrual of the interest deduction along with the inclusion in income by the holder at a time prior to the payment of cash. Interest income may be taxed at a higher rate to a taxable holder than the holder’s dividends or capital gains (to which lower tax rates currently apply). However, some forms of debt investments are not subject to U.S. tax or are taxed at reduced rates in the hands of a tax-exempt or foreign investor. A number of special 1 This document may be cited as follows: Joint Committee on Taxation, Overview of the Tax Treatment of Corporate Debt and Equity (JCX-45-16), May 20, 2016. This document can also be found on the Joint Committee on Taxation website at www.jct.gov. 1 rules in the Code are designed to protect the corporate tax base by limiting the tax benefits that can be obtained from interest deductions. To the extent that debt finances assets that produce tax-exempt or otherwise tax-favored income, the interest deduction is available to offset other income taxed at higher rates. The resulting tax arbitrage can shelter otherwise taxable income. A number of special rules in the Code are directed at limiting this effect. In the event of financial difficulty, the discharge or restructuring of debt can cause the issuer to recognize discharge of indebtedness income or, alternatively, gain with respect to the satisfaction of nonrecourse indebtedness for less than the outstanding amount. The income tax treatment of debt discharge depends on whether the debt is recourse or nonrecourse, the nature of the borrower’s assets and of the borrowing, and the circumstances of the restructuring or discharge. In a number of instances, no current income is recognized, though tax attributes such as net operating losses, credits, or the basis of assets may be reduced. By contrast, the failure to pay dividends or return an equity investment in full does not cause income or gain to be recognized by the issuer. In classifying an instrument as debt or equity, many factors have been applied by courts. In general, a debt instrument requires a fixed obligation to pay a certain amount at a specified date. Debt instruments provide for remedies, including priorities in bankruptcy in the event of default. However, an instrument designated and respected as debt for tax purposes may have features that make it less likely to cause bankruptcy in the event of a downturn: for example, a delayed period before payment is due, the ability to miss scheduled payments over a period of time before default occurs, the ability to satisfy required payments with instruments other than cash, limits on the thin capitalization of the issuer, or ownership of the debt by equity owners who may be willing to modify its terms. Conversely, an instrument designated and respected as equity for tax purposes may have features that are more economically burdensome to the issuer, such as significantly increased dividend payment requirements after a specified period, puts and calls having the effect of requiring a cash redemption by a specified date, or provisions giving the holders certain corporate governance rights in the event scheduled payments are not made. Equity can be beneficial for tax purposes in certain cases. Although corporate distributions and sales of corporate stock subject the holder to tax in addition to any tax paid by the corporation, reduced tax rates apply to holders with respect to such distributions or gain. Dividends on corporate equity are largely excludable by corporate holders (currently resulting in a maximum 10.5-percent tax rate under the 70-percent dividends received deduction). For individual shareholders, both dividends and capital gains on the sale of corporate stock are generally subject to a maximum 23.8-percent rate (compared to the top individual rate of 43.4 percent).2 The present value of the shareholder-level tax on corporate earnings may be reduced
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